Recording 1: Shares and Dividend Discount Model

FIN222 Lecture 3
Share valuation
Chapter 7

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Lecture 3 Chapters Lecture 4 Chapters Learning Outcome 1

• 7.1 • 11.1 1. Demonstrate an understanding of how
• 7.2 • 11.2 financial system works and calculate the value
• 7.3 • 11.3 of different types of cash flow streams
• 7.4 • 11.4 including financial assets such as shares and
• 7.5 bonds.
• 11.5
• 7.6
• 12.1
• 12.2
• 12.3
• 12.4
 Notations What are we learning today?
• Pt = Price in year t
• Based on what we learnt in Week 1,
• Dt=Divt= Dividend per share in year t – How to compute PV of different types of Cash-flows
(CFs)
• g= growth rate = capital gain rate
• Can we apply this to valuing financial assets?
• n= number of periods – We learnt how to value debt security (bonds) last
week!
• rE=Equity cost of capital = Cost of equity
– This week, we learn how to value shares.
• + Basics of ordinary shares, preference shares

Interests &
CFs
Available for Principal
PV= •Discount rate
Debt-holders (1+y)k •Market interest rate
Issue Securities •Yield
•Yield to Maturity
•Cost of debt
TAX •Required rate of return
Ordinary Shares Preference Shares Bond for debt-holders
(Debt)
CFs Dividends
Available for PV= •Discount rate
Shareholders rE •Cost of equity
•Required rate of return
for shareholders
 Debt vs Equity Ordinary Shares
Characteristics Debt Equity Shareholder rights
Cash Flow Interest, principal Dividend • Right to share proportionally in dividends
-Tax deductible? Yes No – Shareholders are paid dividends in proportion to the
number of shares they own
- Legally enforceable? Yes No
– The board decides the timing and amount of each
- Size Variable? No. Fixed Yes. Variable dividend
• Right to share proportionally in assets
Maturity Fixed Indefinite
remaining after liabilities have been paid in a
Asset Claim First Residual liquidation
Voting Right No Yes • Right to vote on directors and other proposals.
Example Bonds Shares
– the right to influence company management
through the election of a company's board of
directors and voting on other important matters.

Preference Shares Regardless, I am

Share Valuation…where do we start?
• Cumulative preference shares treated as equity.
– All previously missed preference dividends must be paid
before any ordinary dividends
Cn

• Non-cumulative preference shares C1 C2 C3 Cn
– Missed dividends do not accumulate. PV = n3
2
1
4
• Hybrid security having features of both debt and
equity
(1+ r)
– Equity Characteristics
• Dividends paid, declared by the board of directors • What are the three key variables needed in asset
• Dividends can be skipped (for non-cumulative ones)
• Can be perpetual
valuation?
– Debt Characteristics – Future Cash flows (C)
• Fixed dividends regardless of firm’s earnings
• Paid before ordinary shareholders – Discount rate (r)
• Typically no voting rights – No of periods (n)
– Some preference shares give preference shareholders
the right to vote if the firm is substantially behind with
paying dividends.
• Can have a fixed maturity
 THE DIVIDEND-DISCOUNT MODEL A one-year investor
CASH FLOWS 0
rE=20%
1
• Dividends (D=Div) Buy Share $8+$100
• Share price when sold P0 D1 + P 1
DISCOUNT RATE (rE) PV (Share) = PV (Dividend) + PV (Sale Price)
• Required rate of return for shareholders $8 $100
= +
• Cost of equity 1 + 0.2 1 + 0.2
NO OF PERIODS $8 + $100 $108
= = = $90
• … think about infinite nature of a share 1.2 1.2
• No maturity therefore D1 + P1
• ∞ P0 =
1 + rE
Q: How would you compute P1?

A one-year investor A multiyear investor

1 2 P0 (D1+P1)
rE=20%
P1 (D +P )
P1 D2 + P 2 D1 P1 2 2
P0 = + P2 (D3+P3)
D2 + P2 1 + rE 1 + rE
P1 = Q. How would you compute P2? D2 + P2
1 + rE D 1 + rE D D +P
2 3 P0 = 1 + = 1 + 2 22
rE=20% 1 + rE 1 + rE 1 + rE (1 + rE )
P2 D3 + P 3 D3 + P3
D D2 (1 + rE )
D3 + P3 = 1 + 2
+
P2 = 1 + rE (1 + rE ) (1 + rE )2
1 + rE D1 D2 D +P
= + 2
+ 3 33
1 + rE (1 + rE ) (1 + rE )
Perpetual Model Dividend-discount model equation
D D2 D3 D∞
∞
Dn
P0 = 1 + +
1 + rE (1 + rE )2 (1 + rE )3
+ ... +
(1 + rE ) ∞
=  (1+ r )
n =1
n
… E
P0 (D1+P1)
P1 (D2+P2) P0 = PV (All future dividends per share)
P2 (D3+P3) • This general model
Pn-1 (Dn+Pn) – Doesn’t assume any specific pattern for future
dividends
D1 D2 D3 D tn Pn
P0 = + 2
+ 3
+ ... + n
+ – Doesn’t assume when the stock is going to be sold
1 + rE (1 + rE ) (1 + rE ) (1 + rE ) (1 + rE )n
t
– Says that to compute a stock’s current value, we need
n -> ∞ to forecast an infinite number of dividends…Feasible?
D1 D2 D3 D∞ P∞  Therefore, it is difficult to use this general model…
P0 = + + + ... + +
1 + rE (1 + rE )2 (1 + rE )3 (1 + rE )∞ (1 + rE )∞

So let’s make some simplifying

assumptions
• In relation to the pattern of dividends
1. Dividend payments remain constant over
time having a growth rate of zero
Recording 2: Three Dividend Models
 Zero-dividend growth
2. Dividends have a constant growth rate
 Constant dividend growth
3. Dividends have a mixed growth rate pattern
 Non-constant dividend growth

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 Zero-Growth Dividend Model Constant Dividend Growth Model
D D D D D D (1+g) D(1+g)2 D (1+g)3 D(1+g)4...
|____ |__ _______ |____ ___ __|______ _| . . . . . |____ |__ _______ |____ ___ __|______ _| . . . . .
0 1 2 3 4 ....
0 1 2 3 4 ....
Div
P0 = Div1 Div 0 (1+ g) 1st future cash flow=
rE P0 = = Dividend at year 1
• Example 1. ABC Ltd has current earnings of $5 per share.
rE - g rE - g
It does not reinvest any of its funds and pays out all the • Example 2. DEF Ltd is a fast growing company with
earnings as dividends. ABC Ltd is not expected to show current earnings of $1 per share. These earnings have
any earnings growth in the foreseeable future. The been growing at a rate of 6% p.a. but only 25% of
required return for shareholders is 12%. What should be earnings are paid out as a dividend. The required return
the price of the firm’s stock? for shareholders is 12%. What should be the price of the
firm’s stock?
Div =$5/0.12=$41.6 per share Div1 Div 0 (1+ g) 0.25(1+ 0.06)
P0 = P0 = = = = $4.42
rE rE - g rE - g 0.12 - 0.06

Changing growth rates Non-Constant Growth Dividend Model

Non-Constant Growth Dividend Model Non-constant Growth Constant Growth at 6%

rE=15% $1 $2 $3 $3*(1.06) $3*(1.06)2 $3*(1.06)3

P0=? D1 D2 D3 D4 D5 D6
• P3=D4/(rE-g)

P0=PV (Mixed dividend growth) + PV(Constant dividend growth)

D1 D2 D3 P3
P0 = + + +
(1 + rE ) (1 + rE )2 (1 + rE )3 (1 + rE )3
3.18
D4 = D3 (1 + g) = $3(1.06) = $3.18 P3 = = $35.33
0.15 − 0.06
$1 $2 $3 $35.33
P0 = + 2
+ 3
+ = $0.87 + $1.51 + $1.97 + $23.23
(1.15) (1.15) (1.15) (1.15)3
= $27.58
 Alternatively,
Example 3. CCC Ltd will pay dividends of $5.00, $6.25, Example 4. CCC Ltd will pay dividends of $5.00, $6.25,
$4.75, and $3.00 for the next 4 years. Thereafter, the $4.75, and $3.00 for the next 4 years. Thereafter, the
company expects its growth rate to be at a constant rate company expects its growth rate to be at a constant rate
of 6 per cent. If the required rate of return is 18.5 per cent, of 6 per cent. If the required rate of return is 18.5 per cent,
what is the current market price of the share? what is the current market price of the share?

– –
rE=18.5% $5 $6.25 $4.75 $3 $3(1.06) $3(1.06)2 ..
rE=18.5% $5 $6.25 $4.75 $3 $3(1.06) $3(1.06)2 ..

P4=D5/(rE-g) P3=D4/(rE-g)
3(1.06) 3
P4 = = $25.44 P3 = = $24
0.185 − 0.06 0.185 − 0.06

$5 $6.25 $4.75 $3 $25.44 $5 $6.25 $4.75 $24

P0 = + 2
+ 3
+ 4
+ = $25.95 P0 = + + + = $25.95
(1.185) (1.185) (1.185) (1.185) (1.185)4 (1.185) (1.185) (1.185) (1.185)3
2 3

Example 5. FIN222 Ltd forecasts the following growth rates

for the next 3 years: 30 per cent, 25 per cent, and 18 per cent.
The company then expects no growth for the future and
Year 3 dividend is expected to be maintained. The company
just paid a dividend of $0.65. If the required rate of return is
12 per cent, what is the market value of this share?
0.65 0.65(1.3) D1(1.25) D2(1.18) D2(1.18) D2(1.18) D2(1.18) ..
Recording 3: rE, g and their impact on P
0.65 0.845 1.05625 1.2464 1.2464 1.2464 1.2464 ..

𝑃2 = 𝐶/r = 1.2464/0.12
=10.39

. . .
( . ) ( . ) ( . )

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Two Components of rE How to calculate g?
Dividend Yields vs Capital gains Div1 Div1 rE =
Div1 P1 − P0
+
1. rE = +g g = rE − P0 P0
• Let’s start from a constant dividend growth model. P0 P0
YOU WILL SEE THIS
Div1 2. When you know both P1 and P0 IN THE FORMULA SHEET!
P0 =
rE − g P1 − P0
g=
• To see the components of rE, let’s rearrange the above P0
in terms of rE. 3. When you know retention rate and return on new investment
= Retention rate X return on new investment
Div1 NOT IN THE
rE = +g Where Retention rate = 1- dividend payout ratio
FORMULA
Total Return:
•The sum of a P0 SHEET!
share’s Dividend Capital gain rate:
yield and Dividend yield: •Return arising from
its capital gain
rate
•Return arising from Stock price rise (due to firm’s growth).
• g= rate at which a firm grows.
g = retentionRate * returnoninvestment
Income component.
•Relevant to dividend (or the value of investment grows.)
Paying companies

• Example 6
FIN222 Ltd has a current share price of $30 and is
Relation between div, g, rE and P
Crane Sporting Goods expects to have earnings per
expected to pay a dividend of $0.5 in one year. Its share of $6 in the coming year. Rather than reinvest
expected share price right after paying that dividend is these earnings and grow, the firm plans to pay out all of
$32. its earnings as a dividend. With these expectations of
no growth, Crane’s current share price is $60.
a. What is FIN222 Ltd’s cost of equity? P0=$60 when g=___0 (all earnings are paid out as div)
0.5 32 − 30 Suppose Crane could cut its dividend payout rate to
𝑟 = + = 0.08333 75% for the foreseeable future and use the retained
30 30 25% $4.50
earnings to open new stores.Retention rate= ____,Div 1=____________
b. How much of FIN222’s cost of equity is expected to be
The return on investment in these stores is expected to
satisfied by dividend yield and how much by capital
be 12%.
gain? =0.25*0.12=0.03=3%
0.5 g= retention rate x return on investment______________
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 = = 0.01667 If we assume that the risk of these new investments is
30
the same as the risk of its existing investments, then the
32 − 30 firm’s equity cost of capital is unchanged.
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑 = = 0.06667
30 What effect would this new policy have on Crane’s
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 Relation between div, g, rE and P
• When g=0 (i.e. no retention of earnings)
Div1 $6
rE = +g= + 0 = 0.1 = 10%
P0 $60
• When payout ratio =75%,
Recording 4: Total Payout Model
Div1 $ 4 .5
P0 = = = $64.29
rE − g 0.1 − 0.03
Retain more of earnings  div ___  g ___
By investing in a project that offers a rate of return
(12%) great than the cost of equity (10%), Crane has
created value for shareholders  P___
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SHARE REPURCHASES AND TOTAL PAYOUT MODEL - Example

THE TOTAL PAYOUT MODEL
• Share repurchase
– A transaction in which a firm uses cash to buy back its own
shares $860 mil * 0.50 =$430 mil
– Alternative way to distribute earnings to shareholders
• Remember! In the dividend-discount model,
P0=PV (Future dividends per share) Growing
• In the total payout model, we consider the TOTAL 0.075 0.1 perpetuity
amount of earnings distributed via both share
repurchases and dividends. Therefore,
430mil
= 17 , 200, 000, 000
0.1 − 0.075
PV(Future total dividends and net repurchases)
P0 = _____________
$17,200,000,000
Shares outstanding0 P0 = = $79.26 per share
217,000,000
• Example 7: AHU Industries has 100 million shares Summary
outstanding and expects earnings at the end of this year of
500 million. AHU plans to pay out 60% of its earnings in total, • What are rights of ordinary shareholders?
paying 40% as a dividend and using 20% to repurchase • What are the debt/equity characteristics of
shares. If AHU’s earnings are expected to grow by 5% per preference shares?
year and these payout rates remain constant, determine • Can you value a share using the Zero Dividend
AHU’s share price assuming an equity cost of capital of 12%. Growth Model?
• Total payouts1 = $500 million (0.60) = $300 million. • Can you value a share using the Constant Dividend
Growth Model?
𝑇𝑜𝑡𝑎𝑙 𝑃𝑎𝑦𝑜𝑢𝑡 • Can you compute a future stock price when
𝑃𝑉 𝑇𝑜𝑡𝑎𝑙 𝑃𝑎𝑦𝑜𝑢𝑡𝑠 =
𝑟 −𝑔 dividends are assumed to grow at a constant rate?
• Can you value a share when dividends growth
patterns are non-constant during early periods and
. . then become constant at a later stage?
Dividing this value by the current number of shares outstanding gives us • What are the two components of the cost of equity
the price per share.
(rE) and can you calculate the value of each? (ie.
Dividend yield and g)
• Do you understand what a share repurchase is?
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• Can you value a share using a total payout model?